This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

The Muni Junk Pile

In the staid world of the bond markets, high-yield municipal funds have been enjoying their version of a roaring bull market. During the three years ending September 30, 2006, the average fund in the category returned 7.0 percent, according to Morningstar. In contrast, the Lehman Brothers Aggregate Index--a bond benchmark--returned 3.4 percent. The results of the munis look particularly impressive because they are nearly all tax free. For a shareholder in the top tax bracket, the average high-yield muni fund produced returns that were equivalent to a taxable bond yielding more than 10 percent.

The strong showing can be attributed to a peculiar combination of factors. After the terrorist attacks of September 11, investors focused on safe issues. That helped depress prices of municipal bonds with ratings below investment grade. Then as the economy improved in 2003 and 2004, confidence in riskier bonds returned. With default rates at minuscule levels, yield-starved investors poured into high-yield munis, pushing up prices.

Can high-yield munis continue producing such big results? Probably not. After the rally, prices are no longer at bargain-bin levels. Yields on many below-investment grade municipals are 6 percent or so, down sharply from what they were paying three years ago. Still, default rates remain tiny, and the munis could be a welcome addition to a fixed income portfolio at a time when 10-year Treasuries yield only 4.5 percent.

Which high-yield municipal fund makes the best choice? To pinpoint a winner, Wealth Manager again turned to the eight-part screen developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The search reduced the field from 79 selections down to 16. Top choices included Nuveen High-Yield Municipal, Eaton Vance High-Yield Municipal, and Federated Municipal High Yield. But we awarded the title to Oppenheimer Rochester National Municipals because it had by far the top five-year returns and highest alpha.

Oppenheimer achieved its record by following its own course. While some funds avoid bonds rated B or below--the bottom ranks of the junk world--Oppenheimer plunges in. Portfolio manager Ron Fielding and his team of credit analysts love to find issues that deserve higher marks than they have received. The aim is to locate bonds that deliver fat yields and reasonable risks. For security, the fund is broadly diversified, holding more than 800 positions.

Fielding has scored some of his best gains with tobacco bonds, issues that many other managers wouldn't buy. The bonds were created after the states attorneys general agreed to collect about $246 billion from tobacco companies. The money was to be paid gradually over 25 years. To gain faster access to the cash, some states issued bonds backed by tobacco revenues. Many investors were wary of the bonds because they feared that courts would overturn the deals. "A lot of people wouldn't touch the bonds because they were new and untested," says Fielding. "We saw that the issues weren't likely to default, and they yielded 400 basis points more than AAA-rated municipals."

So far Fielding's view has proved correct. During the four years that he has held tobacco bonds, the prices have skyrocketed, as investors gained confidence in the issues.

Another big success has come with airline bonds. These issues have frightened many investors who worry about airline bankruptcies. But Fielding has been careful to buy only bonds that are backed by secure collateral. Such bonds continue making interest payments, even after the issuers go into bankruptcy.

Among Fielding's top performers are bonds issued by Eastern Airlines 16 years ago. The airline used the cash to construct a new terminal at LaGuardia airport in New York. When Eastern went bankrupt and then out of business, the space was occupied by Continental Airlines, which continued making payments on the bonds. Then Continental went bankrupt, and U.S. Air took over the terminal. Again there was no interruption in bond payments. "Space is scarce at LaGuardia," says Fielding. "When an airline gives up its gates, there are plenty of bidders ready to move in."

Lately Fielding has been interested in land development bonds. These are used by developers who need cash to build roads and infrastructure in subdivisions. Property taxes from the land cover the bond payments. After lots are developed and sold, the new homeowners continue paying taxes that cover the bonds. The biggest risk to investors is that the developer will abandon his land and no one will take it over. To avoid the problem, Fielding sticks with developments that seem to enjoy strong demand. He recently bought bonds from Palm Beach County, Fla. Located near the tony city of Palm Beach, the new development is four miles from the Florida Turnpike, an area where housing demand is strong. "Even if the residential market nationally slows down now, the land near Palm Beach will hold its value," says Fielding.

The Palm Beach deal is unrated. Because the project is small, the developer did not want to pay the price of being rated by Moody's or one of the other agencies. The lack of rating is fine with Fielding. He figures that the issue is solid. And without a rating, the bonds will have to provide extra yield to attract investors. That will help Fielding deliver the kind of top returns that his shareholders have come to expect.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a business writer and has long been a regular contributor to Wealth Manager.